Economic Systems Economic Systems Chapter

Economic Systems
Chapter 2
Key Concepts
 Pure command  The Soviet model
economic systems  Economic systems and
 Pure market economic social well-being
systems  Surplus
 Transitional economies  Shortage
 Competitive markets  Turnover tax
 Monopolistic markets  Infrastructure
 Imperfectly competitive
markets
Economic Systems: Two Sides of
the Spectrum
 Cold war between the United States and the
Soviet Union (the USSR)
 Two very different economies
 Dissolution of the USSR in December 1991
 The ongoing transition process
The Former Soviet Union
The Continuum of Economic
Systems
 All economies in the world fall in
between the two classes of economic
systems:
 Pure market economy
 Pure command economy
Pure Market Economy
 Pure market economy: economic system based on
private ownership and control of resources, known as
private property rights, and coordination of resource-
use decisions through markets
 Private ownership of resources
 Decentralized decision making coordinated through markets
 Examples: U.S., Canada in early 1800s
Pure Command Economy
 Pure command economy: economic system characterized by
state ownership and/or control of resources and centralized
resource-use decision making
 Mirror image of pure market economy
 State ownership of resources
 Centralized planning
 Markets are not necessary in pure command economies
 Examples: the Soviet Union, North Korea, Cuba
Mixed Systems
 Mixed systems
 Economies that combine elements of the pure
market and pure command economies
 Examples: US, Canada, South Korea, Japan, China,
Vietnam today
 Transitional economies: a nation in the process of
replacing an economic system of command and
control with the one based on market principles
(former USSR and Eastern Europe)
Market Structures
 Purely competitive markets
 Purely monopolistic markets
 Imperfectly competitive markets
Purely Competitive Markets
 Large number of buyers and sellers
 Standardized product
 Prices are free to move up or down
 No obstacles to enter the market
 Buyers are free to choose who to buy from
Purely Monopolistic Markets
 Only one seller of the product
 The seller can set the price at any level
 The seller can block potential entrants from
entering the market
 Higher prices and lower quantities for
consumers
Imperfectly Competitive Markets
 Exhibit characteristics of both pure
markets and purely monopolistic
environment
 Most markets are imperfectly
competitive
Demand: Re-cap
 Demand schedule and demand curves
 Law of demand
 Factors influencing demand
 Consumers’ income
 Prices of related goods
 Consumers’ tastes
 Consumers’ expectations
 Number of consumers
Changes in Quantity Demanded
versus Changes in Demand
Factors Changing Demand
 Consumers’ incomes
 Normal good: the one whose demand increases as incomes rise (most goods are
normal)
 Inferior good: the one whose demand decreases as incomes rise (typically old-
fashioned goods, goods for the poor people)
 Changes in related prices
 Substitute goods: two goods for which an increase in the price of one leads to an
increase in the demand for the other
 Complementary goods: two goods for which an increase in the price of one leads to a
fall in the demand for the other
 Changes in consumers’ tastes or expectations
 When tastes change in favor of a good, demand shifts outward (you want to buy more
at each price)
 Advertising, health information, life style changes…
 Changes in the number of consumers
 More consumers buy more causing the outward shift of the demand curve
Supply: Re-Cap
 Supply schedule and supply curve
 Law of supply
 Factors influencing supply
 Cost of production
 Prices of goods related in production
 Sellers’ expectations
 Number of sellers of the product
Changes in Quantity Supplied
versus Changes in Supply
Factors Changing Supply
 Changes in cost of production
 Increase in production costs pushes the supply curve inwards (at each
price of output suppliers are willing to produce less)
 Advances in technology push the supply curve outwards
 Prices of goods related in production
 Increases in price of related goods reduces the supply
 Sellers’ expectations
 Expectations of increased prices in the future reduce the current supply
 Expectations of improved economic climate increase supply
 Changes in number of sellers
 More suppliers produce more
Competitive Market Price
Determination
Equilibrium
 Equilibrium price is the price at which the sellers of a product wish to sell
exactly as much as the buyers want to buy
 Equilibrium quantity purchased is the quantity of the product that is actually
exchanged at the equilibrium price
 Effects of a price above equilibrium
 Prices above equilibrium level result in surplus
 Resources used to produce the surplus amount (of e.g. pizza) could be better used
producing something else (pressure to reallocate)
 Surplus exerts pressure on producers to reduce prices
 Effects of a price below equilibrium
 Prices below equilibrium level result in shortage
 Shortages indicate that more resources should be used to produce the product
 Shortages exert pressure to increase prices
The Soviet Model
 War Communism (1917-1920)
 No market allocation of resources
 Nationalization of important industries
 Forced requisition of agricultural output
 Elimination of private property rights and markets
 New Economic Policy (1920-1928)
 Re-cap: tragedy of the commons
 Mixed-command economy through return to private property rights
 Reintroduction of the market as chief mechanism of resource allocation
 System of Central Plan (1928)
 Centralized planning
 Control
 100 ministries produced 14000 pages of plans each year for the production and
distribution of 24 million products
 Planning problem: how much to produce (quantities) and how to produce
(technologies)
 Huge coordination problems resulted in a limited scope of choice
Market Economy Reaction to
Changes in Demand
 Suppose rising incomes push demand curve
outwards
 Prices increase
 Quantities increase
 Suppliers react to increased prices by
producing more (outward shift of the supply
curve)
 Quantities increase yet more
 Prices go down (but maybe not down to the
previous equilibrium level)
Market Economy Reaction to a
Change in Demand
Command Economy Reaction to
Changes in Demand
 The supply curve is vertical in the command economy meaning whatever the
price, the output level stays the same
 Prices indicate little if anything about the cost of producing a product
 Profits get siphoned off by a turnover tax (like a sales tax)
 Prices would be held down to the market-clearing level by providing a subsidy
to the loss-making industries
 Increases in demand (e.g. due to changes in tastes) result in shortages since
central planners keep their plan targets fixed
 Even if prices are allowed to increase, all additional profits go to the state
through the use of turnover tax
 Prices do not serve as signals for optimal allocation of resources
Command Economy Reaction to a
Change in Demand
Relative Position of the Soviet
Consumer in 1985
Former Soviet Republics,
2000-2001